Video: Adjusting Entries: Definition, Types & Examples

Adjusting entries are a very important part of the accounting cycle because they ensure that you are reporting the company's financial situation accurately. In this lesson, you will learn which accounts need adjusting and how those adjustments are made.2017-02-01

Adjusting entries are a very important part of the accounting cycle because they ensure that you are reporting the company's financial situation accurately. In this lesson, you will learn which accounts need adjusting and how those adjustments are made.

What Are Adjusting Entries?

Adjusting entries are journal entries made at the end of an accounting cycle to update certain revenue and expense accounts and to make sure you comply with the matching principle. The matching principle states that expenses have to be matched to the accounting period in which the revenue paying for them is earned.

There are four main types of accounts that need to be adjusted:

Prepaid expenses

Accrued expenses

Unearned revenues

Accrued revenues

Prepaid Expenses

Prepaid expenses are expenses that have been paid in advance, like paying your rent for six months all at one time. The thing is, you can't actually record the whole six months of rent as an 'expense' right away because the money really hasn't been spent yet. For instance, what if something happens three months into your lease which prevents you from renting the office, and the landlord has to return some of your money? Right now, that prepaid rent is actually an asset.

According to the matching principle, you have to match the cost of the rent for each month to money earned in that month. So, when you first make a prepaid expense payment, you record the entire amount as an asset. At the end of each successive accounting period, you can record the used-up portion of the prepaid expense as an expense. Prepaid expenses that need an adjusting entry usually include things like rent, insurance and office supplies.

For example, your first month's rent is due on March 1. Your office rent is $500 per month, and you decide to pay for an extra six months all at once - April to September. On March 1, you give the landlord $3,500 in cash and record the transactions in your journal like this:

First, you record a regular journal entry for the $500 payment as a debit for rent expense and a credit to cash.

You also record a regular journal entry for the $3,000 that you paid in advance as a debit to prepaid rent and a credit to cash like this:

In April, you'd make an adjusting entry to account for the used-up of part of the prepaid rent by recording a $500 rent expense as a debit and crediting $500 as prepaid rent. You now have a balance of $2,500 in your prepaid rent account.

Finally, in May, June, July, August, and September, you'd make more adjusting entries to record the rent expense payments in the same was as you did in April. The balance in the prepaid rent account will be $500 less each month, so after recording the September payment, the balance in the prepaid rent account would be zero.

Accrued Expenses

Accrued expenses are expenses that build up over the accounting period, but you don't pay for them until after you use them, like utilities. Think about your own utility bill: all month long, you accrue charges for the utilities you're using, like heat, light, and water. You don't know how much your bill will be until after you receive one from the utility company, so you can't even pay for the energy you used until the end of the month. This makes it a payable, or a liability, which is the amount you owe. Unlike prepaid expenses, which need multiple adjusting entries, accrued expenses require only one adjusting entry for the amount of the expense. Accrued expenses include things like utilities, employee wages, employee salaries, interest, and taxes.

Let's say Baker Construction has a loan, or note payable, of $100,000 at 1.2% annual interest. The total interest for the year is $1,200, but the company records the interest as it accrues, at the end of every month. So, it will record a $100 debit to the interest expense account and a $100 credit to interest payable account every month for 12 months. This what the adjusting entry for one month would look like:

Unearned Revenue

Unearned revenue is money you receive from a client for work you'll perform in the future. It is considered a liability because you still have to do something to earn it, like provide a product or service. Unearned revenue includes things like a legal retainer or fee for a magazine subscription. The lawyer still owes the client work in return for the fee that he or she has already taken, and the magazine company owes the client magazines for the length of the subscription.

For instance, a lawyer receives a $50 cash retainer fee from a client for which his accountant debits the cash account and credits the unearned revenue account. The adjusting entry would look like this:

Accrued Revenue

Accrued revenue is money you've earned but not yet recorded yet for some reason. Like utilities, it generally builds up over time, and you don't know exactly how much it will be until you submit a bill. Accrued revenue is common in service industries like consulting or technical support services, where the service is provided over time and billed periodically.

Let's say IT Co. provides technical support services to Jim's Shoes and charges them $50 per call. During the month of July, Jim's Shoes makes four calls for technical support. At the end of July, IT Co. sends Jim's Shoes a bill for $200. IT Co. will record this accrued revenue as a $200 debit to accounts receivable and a $200 credit to fees earned:

Lesson Summary

Adjusting entries an important part of the accounting cycle and are made at the end of an accounting period. They are used to update revenue and expense accounts to make sure that expenses are matched to the accounting period for which you've earned the necessary revenue, as required by the matching principle.

The four main types of accounts that need to be adjusted are:

Prepaid expenses, which are expenses that have been paid in advance

Accrued expenses, which are expenses that are accumulating over the accounting period

Unearned revenues, which are revenues that you still have to provide a service or product for

Accrued revenues, which are revenues that are accumulating during the accounting period

Summary:

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